III. The information economics of securitisation.

• Author: Jobst, Andreas A.
• Position: Collateralised Loan Obligations (CLOs

The mechanics of bank-based loan securitisation lend themselves to models of information economics, as the sale of selected asset claims by issuers raises issues involving concepts of asymmetric information and decision-making under uncertainty. As much as the non-diversifiable idiosyncratic risk inflicts some degree of illiquidity on the reference portfolio of bank loans, the fundamental motivation of loan securitisation substantiates this notion. At bottom, the conduct of CLOs garners issuers with a range of options in improving the credit quality of their loans by means of incorporating structural and credit enhancement, such that investment grade debt securities can be issued to capital markets.

However, private information about the credit quality of loans restricts the scale of securitisation in view of the way information asymmetries adversely impact on the marketability of bank loans. Illiquidity fuels the most intuitive, though paradox, objection to an efficient securitisation of loans, notwithstanding the fact that the complete absence of asymmetries would render the securitisation of illiquid assets unprofitable, as it scuppers efforts to diversify bad risk across a selected asset pool. Loans are non-standardised, non-commoditised claims due to opaque nature of the lender-borrower relationship.

For illiquidity trims the market value of asset claims, the securitisation structure of a CLO could mute such adverse effect on the value of the reference portfolio. By extension, the securitisation increases the average value of the reference portfolio to a selling price beyond what would be deemed necessary to at least offset the management cost associated with a securitisation. Hence, the detrimental effect of illiquid assets on the bank balance sheet can be extenuated by virtue of securitisation structures. However, their efficiency-improving effect is conditioned on the "capitalisation" of the financial system of the respective jurisdiction, which arguably signals the importance of market transparency of borrower fundamentals in external finance (e.g. relationship lending, etc.). In general terms, the economic effects induced by information asymmetries and illiquidity of the securitised collateral portfolio will inevitably determine the security design of the CLO transaction. Generally speaking, market implications of private information, i.e. adverse selection and moral hazard, as well as trading costs, are the sources of illiquidity, which impose limits to the degree of securitisation of loans.

1. Adverse Selection

   Since the presence of asymmetric information qualifies as an element of uncertainty, investors assume the existence of adverse selection to occur in the spirit of the lemons market a la Akerlof (1970). (24) Such beliefs are compounded in their effect on asset pricing of securitisation transactions by the attendant degree of private information associated with loans, amid the apprehensive stance of banks towards disclosing their credit risk assessment methodology applied in assessing the creditworthiness of debtors. Assuming unilateral information advantage by issuers induces ex ante moral hazard in the asset selection process (see also Exhibit 19 in section III.B), rational investors anticipate being misled by issuers of a securitisation transaction, who are sure to be in a better position to judge the true credit quality of the reference portfolio.

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   Given some uncertainty about the true value of the credit quality of the underlying reference pool of loans, investors will expect adverse selection and merely offer a price (average market price) that is on average below the true market price of the reference portfolio under symmetric information. Thus, the estimated value of such private information imposes a lemons premium on the issuer, who could either retain the reference portfolio of loans or sell it by means of securitisation. Even though issuers seek to counteract this effect by bundling assets and then further tranching these bundles before they are sold in capital markets as debt securities, the degree of private information is sanctioned by investors. Conversely, the ability of the issuer to establish maximum transparency about asset quality bears out the discount investors would command as compensation in return for uncertainty about the true value of the reference portfolio.

   CLO transactions cannot exhaustively guard investors against the danger of adverse selection arising from the illiquidity of bank loans. In cognisance of the agency cost of adverse selection issuers of CLOs could suppress the pecuniary charge associated with the lemons premium by soliciting a higher valuation of the reference portfolio. They retain a claim in the performance of the collateral (reference portfolio) as a sign of asset quality in order to overcome the information problem. Since adverse selection can only arise in relation to the downside risk of default risk, the tranching and the allocative mechanism of losses in the structure of a CLO transaction bears critical importance, as they signal the absorption of loan default risk within the transaction. However, only if these provisions help discriminate good from poor issues, market separation through increased transparency can come about. (25)

   Generally, issuers would opt for a combination of both (i) the concentration of credit risk of the underlying reference portfolio in a structural enhancement (see Exhibit 10) and (ii) the tranching of the debt securities issued to investors. In the context of subparticipation, the so-called loss cascading mechanism ensures that small junior tranches find most of the default risk allotted to them, leaving hardly any credit risk to large senior tranches, which could be sold to investors without suffering from price discounting due to adverse selection.

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   In order to achieve high ratings for the senior securities, the conduit must commit to obtaining credit enhancements, which insulate senior securities from the risk of fluctuating payment patterns and excessive default on the underlying loan pool. Credit enhancement is defined as a contractual provision (such as asset retention) to reduce default loss from the reference portfolio eventually borne by the investor. Rating agencies typically require credit enhancement to cover the difference of default probability between the securitised collateral and the desired structured rating of the securitisation transaction.

   One possibility of credit enhancement, for instance, would be if the sponsoring bank of the CLO transaction retains the most junior tranche, which attracts the highest lemons premium from adverse selection, as first loss position (credit enhancement) to cover all expected default loss of the underlying reference portfolio, and possibly accepts further stakes in subsequent tranches of higher seniority (second loss position). In return for credit enhancement as well as the loan origination and servicing functions the sponsor of the transaction appropriates whatever return is to be had from the securitisation net of prior claims by issued debt securities. That is, the gain from securitisation lies in the residual spread between the yield from underlying loans and the interest and non-interest costs of the conduit, net of any losses on pool assets covered by credit enhancements.

   Due to the inherently illiquid nature of the loan pool and the high risk associated with the most junior tranche as the first-loss piece ("equity note"), the marketability of such unrated credit enhancements is limited (Herrmann and Tierney 1999). However, so-called interest subparticipation allows issuers to trade credit enhancements. The mechanism of interest subparticipation has been devised by issuers to reduce the illiquidity of the first loss piece of securitisation transactions in order to ameliorate the marketability of the credit enhancement held as an equity tranche by the sponsor of the transaction. Payments out of available interest generated from the overall reference portfolio are partially used to offset first losses of noteholders of the first loss position. By doing so, the principal amount of the outstanding first loss piece is reduced through the amount of interest subparticipation, in an amount equal to the allocated realised losses. Even though the claim of first loss noteholders to the interest subparticipation is an unsecured claim against the issuer, the economic rationale behind this concept is regulatory capital relief, as no capital has to be held against interest income under the current regulator), standards. Since the first loss piece achieves the rating of the issuer, the placement of" credit enhancement under interest subparticipation is cost efficient. However, the capital efficiency derived from such an arrangement is associated with substantial institutional risk in view of potential future changes in the regulatory framework, which has hitherto not given clear guidance on the capital treatment of the concept of interest subparticipation in the provision of credit enhancement. The new proposal for a revision of the Basel Accord indicates the possibility that the fist loss position will most likely be subjected to a full deduction from capital in this thinly regulated area of structured finance. Given present regulatory uncertainty as to the future capital treatment of structural provisions, such credit enhancement and the interest subparticipation, it is worthwhile incorporating a regulatory call of the first loss piece, which allows for the possible restructuring and subsequent sale of the most junior tranche to capital market investors.

   Nonetheless, retention of credit enhancement--as a sign of willingness to shoulder significant credit risk--could not only allow the sponsor to allay adverse effects of private information associated with asset illiquidity, provided that issuers are...